Running out of money in retirement is a concern most of us share. An international survey of 16,000 workers and retirees found that this was the chief concern among half of those surveyed. Moreover, it’s a fear people experience very intensely: more than 60% of baby boomers fear running out of money in retirement more than death itself.
Unfortunately, it’s a fear that may come true for many retirees: 13 percent of baby boomers in the highest income quartile will run out of money in retirement, while a whopping 28 percent of boomers in the second highest quartile will also run out of money in retirement. These numbers are for people who will be retired for 35 years. The percentages improve for people who will only be retired for 20 years, but not by much.
Why do People Run out of Money in Retirement?
The primary reason for people not having enough money in retirement is that they didn’t save enough along the way. The situation is getting dire: one quarter of non-retired adults have no retirement savings or pension whatsoever. Additionally, less than half of non-retired adults over 60 believe their retirement savings is on track. Income and wealth are strong predictors of retirement account ownership: households with retirement accounts have more than 2.4 times the annual income of households that do not own a retirement account.
The second major reason is underestimating expenses. It’s common wisdom that your expenses will decrease once you enter retirement – no more commuting, decreased vehicle costs, lower taxes, etc. However, there are a number of other expenses that could very well rise once you’ve retired, such as travel, healthcare, and shopping. As a matter of fact, nearly half of U.S. households spend more money during the early years of retirement than they did when they were still working. Without proper planning, you could find yourself running low on funds during retirement.
Starting Retirement with Enough Money Saved
The first step to take to avoid running out of money in retirement is figuring out how much money you’ll need in retirement. To do that, you need an accurate understanding of what you will spend. One way to estimate this amount is to create a detailed retirement budget. Be as detailed and thorough as possible, as this will increase your odds of success in retirement. If you are wired to put together a budget, that is great as it is the best way to determine likely retirement expenses. However, we have found that many HCM clients think budgets is a four-letter word. For these pre-retirees we suggest reverse engineering what you are spending today (total income, less taxes and retirement savings) and using that as a starting point in our planning. Remember that your spending mix will change as you go through retirement – more expenses for travel and entertainment early in retirement, more on healthcare toward the end of retirement – so be sure to factor that in.
Once you have a sense of how much you’ll be spending in retirement, it’s time to take stock of your assets. First, tally up any fixed sources of income you have, such as pensions or Social Security. Your retirement savings will be tasked with making up the difference.
At HCM we see newly retired clients often want to make up for lost time and wind up spending more in the early years of retirement than they did while they were working, with travel and spoiling the grandchildren. Also, don’t forget about things like new cars and home remodeling. With that said, retirement books tend to say that most retirees need about 80% of their pre-retirement income to live in retirement. So, for example, if you made $80,000 per year before retirement, you’ll need roughly $64,000 to maintain your lifestyle in retirement. The average Social Security payment for retirees is about $1,500 per month ($18,000 per year), meaning, absent any pension or other fixed income sources, your savings will need to generate $46,000 per year, or a little more than $3,800 per month, increasing every year for inflation. With this information, it is easy to see the main reason people outlive their savings in retirement – not saving enough. Using the famous 4% rule as a guide, we can solve for how much you need in your retirement portfolio to maintain your quality of life in retirement. If you plan to follow the 4% rule (withdrawing 4% of your portfolio the first year of retirement, increasing the withdrawal every subsequent year to account for inflation), you can divide your first year’s withdrawal ($46,000) by 4% to get the total portfolio value, $1.15 million (note: there are a number of caveats to the 4% rule, but it works well for this purpose). If you’re nearing retirement and haven’t hit your target portfolio value, don’t worry – most retirement accounts have catch-up contribution limits for people nearing retirement, usually 50 and older. If that won’t make up the difference, there are other things you can do to increase your retirement security. The 4% rule was calculated for a 30-year retirement. Pushing back when you start your retirement decreases the amount of work your savings will need to do while adding more income to your pocket, a win-win. If you delay taking Social Security, the benefits you will receive later in life increase at a rate of 8% per year, further reducing the stress on your retirement savings. Alternatively, while in retirement you can add a source of income by working part time. Many people are able to consult in their previous career fields. Plus the recent surge in gig economy jobs means you can click an app, make some money, and then go back to your retired life. Another way to increase the life of your retirement savings is to decrease your retirement budget. Look for things you don’t need, don’t use, and can live without as a way to start cutting your retirement budget. A lot of folks downsize when they go into retirement, which allows them to decrease homecare costs, utilities, and property taxes, while taking on the adventure of living somewhere new. Finally, I can’t stress enough the importance of thoughtful, long-term tax planning. Most retirees decrease their income in retirement, moving them into a lower marginal tax bracket. Today’s situation for retirees is complicated, however, by the fact that so much of their assets are in tax-deferred accounts. In this case, a mismanaged withdrawal schedule or an unaccounted for Required IRA or 401(k) distribution could very well push you into a higher tax bracket. Comprehensive multi-year tax planning can build a strategy to avoid spikes in income, minimizing your total tax burden for the long term and helping to optimize your family’s wealth.
Dealing with Unexpected Expenses in Retirement
So you’ve made it to retirement, things are going well for a few years, when suddenly a monkey wrench gets thrown into the works. Maybe it’s a sustained market downturn, maybe it’s a medical expense, maybe you needed to help out a family member. Whatever it is, your plan needs adjusting.
The biggest X factor in retirement is health care costs. Costs are expected to rise by 5.9% annually through retirement for a couple retiring in 2021, and a couple could easily incur more than $1 million in total healthcare costs throughout retirement. If fact, according to the Fidelity Retiree Health Care Cost Estimate, an average retired couple age 65 in 2020 may need approximately $295,000 saved (after tax) to cover unreimbursed health care expenses in retirement. Of course, the amount you'll need will depend on when and where you retire, how healthy you are, and how long you live.
In this case, the best offense is a good defense. Knowing that healthcare costs are a sure facet of your retirement future means you should start saving now. Fortunately, for those still working, the government’s happy to give you a hand in the form of a Health Savings Account (HSA). An HSA is a tax-advantaged account available to individuals covered by high-deductible health plans to save for qualified medical expenses. Qualified medical expenses include items such as medical, dental, and vision care, as well as prescription drugs, and the CARES Act expanded the qualified expenses list to include over the counter medications and certain other health-related products. Known as a “Roth on steroids,” HSAs are triple tax-advantaged: funds are contributed to the account using pre-tax income, contributions made to the HSA are 100% tax-deductible, with earnings accruing tax-free, and withdrawals from the HSA are not taxed, provided they are used to pay for qualified medical expenses. One way to optimize HSAs is to invest these assets and allow them to compound tax-free until needed later in retirement.
A serious threat to your retirement stability is the possibility of needing long-term care. Not everyone needs it - the U.S. Department of Health and Human Services estimates that nearly half of people who are now 65 won’t have any long-term-care costs – but if you do, the costs can be steep. One-fourth of the population are expected to face skilled care expenses of up to $100,000, and 15% will see bills in excess of $250,000. With Medicare not covering long-term care, you’ll need to find a way to handle this cost yourself.
As part of your wealth planning process, you should determine if you can afford to self-insure the long-term care risk. Long-term care insurance is one tool that some retirees use to reduce their own financial risk. It’s important to shop for this well before you need it but be aware that it is very expensive coverage. It may, however, make sense to purchase, depending on your financial situation.
If you find yourself house-rich and cash-poor in retirement, it may be worthwhile to explore tapping into your home equity to maintain your cash flow. This can also be a tax-smart strategy if the bulk of your retirement assets are in tax-deferred accounts that will be taxed as ordinary income as you take distributions. Traditional mortgages, home equity loans, and even reverse mortgages can make sense in certain circumstances. You might recoil at the idea of borrowing after spending your whole life getting out of debt, but when used appropriately, these can be useful strategic tools.
A reverse mortgage is a loan, guaranteed by the federal government, that allows seniors age 62 and older to tap into their home equity while remaining in their home. The loan is repaid when they move, sell the house, or die. If there’s equity left in the home, the owner or heirs can sell the house and repay the loan, keeping the remainder. If there’s no equity left, they hand the bank the keys and the family owes nothing.
A particularly useful application of this is what’s known as a “standby reverse mortgage.” To do this, you take out a reverse mortgage line of credit as soon as you can and just hold on to it. If the stock market dips or your portfolio takes a hit for some reason, you can use this as a line of credit to pay expenses until your investments recover. This can help avoid the unfortunate situation so many were put in during the Great Recession, when they were forced to liquidate assets at substantial losses to pay bills, threatening the lifetime viability of the portfolio overall.
Of course, there are no free lunches. The up-front costs of a reverse mortgage can be substantial, so it’s best not to pursue one unless you plan to stay in your home for several years. The loan comes due in full when the last surviving borrower sells, leaves for more than 12 months due to illness, or dies.
Running out of money in retirement is a universal concern. Most baby boomers fear it more than death itself. While the future is inherently uncertain, putting a comprehensive wealth management plan in place to guide your retirement gives you the best chance of making sure you’ll live a financially secure retirement.
|Steve Hengehold, CFP® RICP®|
Steve enjoys taking the vision of his clients’ financial future and breaking it down into the small tasks that will get the job done. He is inspired by the big achievements that HCM clients have already accomplished and knows the importance of continuing to work towards their next goals. When not at work, Steve enjoys playing guitar, reading, deferring taxes, compounding investment returns, fishing and SCUBA diving.